FIRST EDITION
The Now Not So Ordinary Meaning of “Ordinary Course of Business”
Background
In our recent article “Pandemic M&A Letter of Intent Checklist (Annotated)” published in Bloomberg Law, we provided guidance on important issues that clients and practitioners should consider when negotiating mergers and acquisitions (“M&A”) transactions in light of the current economic environment. One topic we raised in our article, and which we discuss in greater depth in this inaugural edition of our newsletter, is the effect of the economic shutdown on the seemingly simple, and perhaps once innocuous, phrase “ordinary course of business” that is commonly used in M&A agreements.
The phrase “ordinary course of business” is utilized in M&A agreements to require the target business to operate during the period between the signing and closing of an M&A transaction in a manner that is consistent with the operation of the business prior to signing. In addition, the phrase is also utilized to qualify various representations and warranties of the target business (e.g., since the balance sheet date or other specified period of time), including if (1) the business has not incurred any liabilities except in the ordinary course of business consistent with past practice, and (2) the seller has conducted the target business in the ordinary course consistent with past practice. In a nutshell, the primary purpose for the phrase is to ensure that the condition of the business — upon which a buyer made its valuation — is historically as portrayed to the buyer during due diligence and negotiation of the M&A agreement and also remains relatively unchanged unless otherwise approved by a buyer.
Historically, ordinary course of business has rarely been defined in M&A agreements, with deal participants instead utilizing its plain meaning. This meaning has not been heavily litigated, and historically courts relied on the definition found in Black’s Law Dictionary.1
But what exactly does it mean to operate a business in the ordinary course when facing a disruptive and unexpected event such as the Covid-19 pandemic, particularly when businesses and their customers and vendors are forced to shut down or otherwise operate at a substantially reduced capacity? More specifically, what actions or inactions of a business in response to the Covid-19 pandemic are acceptable as falling within the ordinary course of business? Will sophisticated parties continue to use the plain meaning of ordinary course of business in M&A agreements moving forward?
Changes to Ordinary Course of Business
In an admittedly unscientific (but, we believe, telling) survey, we reviewed 18 private company M&A agreements that were entered into since March 1 and that were either publicly available or in which Katten was engaged as legal counsel. We found that 11 of those M&A agreements specifically defined the phrase “ordinary course of business,” in stark contrast to customary practice prior to the Covid-19 pandemic. In defining that phrase, we are seeing sellers seek to negotiate into the definition (or otherwise into M&A agreements), with varying levels of success, the flexibility to take any action required to respond to the effects of the Covid-19 pandemic and to comply with related laws and directives (e.g., office closures, reductions in workforce, implementation of remote working arrangements and compliance with social distancing and “shelter-in-place” orders). We are also seeing buyers, on the other hand, seek to require sellers to provide notice or obtain the buyer’s consent for a larger number of specific actions, including actions related to the Covid-19 pandemic.
While the definitions of “ordinary course of business” we reviewed vary in complexity, they generally include some of the elements depicted in the following illustrative definition:
“‘Ordinary Course of Business’ means actions taken by the Company that are consistent with the past usual day-to-day customs and practices of the Company in the ordinary course of operations of the business during the period from [ ] to [ ]; provided, however, that (a) seller-friendly: actions or inactions [that the Company reasonably believes are] required to comply with applicable law, directive, guidelines or recommendations of any governmental authority in connection with or in response to the COVID-19 pandemic shall be considered to have been taken in the Ordinary Course of Business . . . and (b) buyer clawbacks: notwithstanding the foregoing, (i) the foregoing clause (a) shall be excluded from the meaning of “Ordinary Course of Business” as such term is used in Section [specify interim operating covenants][specify particular representations and warranties] and (ii) the following actions shall be excluded from the meaning of “Ordinary Course of Business”: [specify actions unique to the business being acquired and about which buyer seeks information].”
In addition to robustly defining “ordinary course of business,” buyers are requiring full disclosure of pre-signing actions or inactions related to the Covid-19 pandemic (e.g., application for a Paycheck Protection Program loan (PPP loan) and the use of such funds and employee terminations, layoffs, furloughs, paid/unpaid leaves of absence or reduced hours). We are also seeing buyers specify which negotiated qualifications will or will not be applicable when such phrase is used in a seller’s representations and warranties, depending on its usage.
Further, in a development related to confirming the conduct of business in the ordinary course, we found that buyers are more closely monitoring the financial condition and operations of the target business during the interim period between the signing and closing of an M&A transaction by requiring sellers to, among other requirements:
• provide a detailed account of the sources and uses of any proceeds received under a PPP Loan;
• use PPP loan proceeds for only permitted purposes that would qualify for loan forgiveness;
• apply timely for PPP loan forgiveness;
• keep the buyer informed of any actions or measures taken in response to the Covid-19 pandemic; and
• deliver periodic (e.g., monthly, quarterly or, in some cases, more frequent) financial statements and other financial or operating information.
Recent Litigation
Not surprisingly, we have seen an increase in M&A litigation as a consequence of the Covid-19 pandemic, including buyers asserting a failure of the target businesses to operate in the ordinary course of business as a basis for terminating pending acquisitions. Thus far, these terminations have occurred in connection with M&A agreements entered into prior to the spread of the Covid-19 pandemic to the United States.
On April 22, an affiliate of Sycamore Partners (SP Buyer) filed a lawsuit seeking a declaratory judgment against L Brands, Inc., the owner of Victoria’s Secret and PINK (L Brands), in order to terminate the purchase agreement between the parties under which SP Buyer would acquire a majority interest in the Victoria’s Secret business.2 During the period between signing and closing, L Brands was required to, among other things, cause “its subsidiaries to conduct the Victoria’s Secret business in the ordinary course consistent with past practice and to use its reasonable best efforts to preserve intact the business organizations of the Victoria’s Secret business and the relationships of the business with third parties and to keep available the services of the business’s present officers and employees.” SP Buyer argued that L Brands breached its covenant to operate the Victoria’s Secret business in the ordinary course of business, when it closed nearly all of the business’ retail stores, reduced the compensation of the business’ employees, drastically reduced the business’ merchandise receipts and failed to pay rent in April for the business’ retail stores in the US. The purchase agreement did not define ordinary course of business. Ultimately the case was voluntarily dismissed after the parties mutually agreed to terminate the transaction.
Similarly, on April 30, an affiliate of China-based Daija Insurance Co. (Daija) filed a lawsuit against Maps Hotels and Resorts One LLC., an affiliate South Korea-based Mirae Asset Global Investments Co. (Maps H&R), seeking a declaratory judgment for breach of contract (and specific performance) after Maps H&R refused to close on its acquisition of 15 luxury hotels in the US.3 The purchase agreement required Daija to conduct the target hotel business “in the ordinary course of business consistent with past practice in all material respects” and to use “commercially reasonable efforts to preserve intact in all material respects their business organization and…the present commercial relationships with key Persons.” In response to claims that it breached this covenant by scaling back hotel operations during the Covid-19 pandemic, Daija argued that its actions were taken in response to governmental orders and to avoid defaulting on its key relationships with lenders and brand partners. We have not seen a copy of the M&A agreement, but we suspect that ordinary course of business is not defined. This matter is still pending.
Takeaways
We believe that the disruptions caused by the Covid-19 pandemic and the risk of future business disruptions from unexpected events has indelibly changed deal participants’ and practitioners’ perception of the M&A landscape. Accordingly, we anticipate the use of a defined, negotiated meaning for “ordinary course of business” to become the norm for the foreseeable future. We further expect parties to carefully negotiate the amount of latitude that target businesses will have during the interim period between signing and closing an M&A transaction to respond to unusual conditions without breaching their M&A agreement. We naturally expect buyers to seek more oversight of operations to preserve value and to be confident that they are purchasing substantially the same businesses they intended to buy, while allowing sellers some flexibility to respond to market conditions with confidence that their transaction will not be derailed.
In our next edition, we will discuss changes to representations and warranties in M&A agreements that parties will likely negotiate in response to the Covid-19 pandemic and the related business disruptions. Further, if you have a particular topic of interest that you would like us to address in the future, please let us know.
1 Tuscarora Corp. v. HJS Indus., Inc., 794 S.W.2d 435 (Tex. App.—Corpus Christi 1990, writ denied); Ivize of Milwaukee, LLC v. Compex Litig. Support, LLC, CIV.A. 3158-VCL (Del. Ch. Apr. 27, 2009). Black’s Law Dictionary (11th ed. 2019) defines ordinary course of business as “[t]he normal routine in managing a trade or business.”
2 L Brands, Inc. v. SP VS Buyer L.P., Case No. 2020-0304-JTL (Del. Ch., Apr. 23, 2020).
3 AB Stable VIII LLC v. Maps Hotels Resorts One LLC, No. 2020-0310-JTL (Del. Ch., Apr. 30, 2020).
For more information about these issues or if you would like to discuss an M&A-related matter, please contact: Greg Hidalgo, Partner at +1.214.765.3686; David Kravitz, Partner at +1.212.940.6354; or Soden Abraham, Associate at +1.469.627.7018.
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